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Sweet Dividends

Dividend reinvestment makes beating the market child's play.

Over the holiday weekend, my wife and I went back to my hometown to visit with friends and family. It's always nice to catch up on old times, but my work here at the Fool inevitably comes up at these little gatherings. As an investing nut, I'm constantly encouraging everyone within earshot to save and invest.

I've been riding one particular friend -- a new father -- to start putting some money to work for his daughter. You see, I missed the opportunity to start investing earlier in life, and I don't want others to pass up the power of reinvesting dividends over time.

My friend understands that he needs to save and invest for his daughter, Bella, but he is wary of stocks because of his past experience as an employee at Lucent Technology(NYSE:LU). In fairness, working at Lucent wasn't so bad, but the investing experience in his 401(k) wasn't any fun. He stashed the majority of his assets into shares of Lucent. As an employee in the late 1990s and for part of 2000, it doesn't take a mathematician to figure out that his largest investment experience to date wasn't very rewarding.

Despite this negative experience, my friend also realizes that some of the problem was his own doing, and he's coming around to the idea that some businesses are more predictable than others -- and that some definitely carry more risk than others. Like me, he also likes the idea of getting part of his return now in dividends.

The power of sugar and brandingLuckily, my friend and I share something in common: a love of sugar. For years I've been subjecting my teeth to sugary beverages from Coca-Cola(NYSE:KO) and PepsiCo(NYSE:PEP), as well as candy and gum from companies such as Hershey Foods(NYSE:HSY). Given the long-term track records of food, candy, and beverage companies and their ability to raise prices over time, it's tough to think of a better place to start. The other reason to love these companies is that they tend to pay dividends that can be reinvested, and many companies even increase their payouts every year.

To prove the power of investing in general, and the importance of adding dividends to the mix, I chose two companies that are often cited as strong performers and have rewarded their shareholders with dividends year after year. In addition, I also wanted to do the math quarter by quarter to prove the benefits of this strategy to myself.

I chose July 1, 1988, as my starting point. That's the approximate day I began earning a regular paycheck and, theoretically, could have begun investing on my own. I was only in junior high at the time and my income was meager, but it was steady. I started with $250 for each investment, and for the sake of mathematical simplicity I specified that no further cash was added but that all dividends were reinvested. If you have children with larger earning power, you can always start with a higher base and use the numbers below to arrive at a far larger total return in dollar terms.

Whatever it is I think I seeThe first stock for my mock exercise is Tootsie Roll Industries(NYSE:TR). We've all been munching on Tootsie Rolls for years, and the company has historically done quite well for shareholders. For my experiment, however, Tootsie wasn't the winner (though it did not do poorly). After starting with a little more than eight shares from the $250 investment, and factoring in reinvested dividends and splits, I'd have over 52 shares worth approximately $1,650 today. That's about a 560% return vs. an S&P 500 return of 345% for the same time period.

Considering that Tootsie pays an annual 3% stock dividend (via a 103-to-100 split ratio) and a little more than 1% in cash each year, that's not bad. Unfortunately, Tootsie Roll's business has been a bit stagnant the past few years, as have the dividends and share price. That said, the company still has a solid balance sheet and generates a strong amount of free cash flow. Considering the long-term performance of the company and the fact that candy doesn't go out of style, investors should keep Tootsie Roll on their radar.

Make a fortune in bubble gumThe other company I looked at is Wrigley(NYSE:WWY). Just like Tootsie Roll, Wrigley has generated absolutely fabulous historical returns for shareholders. In this historical exercise, the original six shares of Wrigley purchased in 1988 ballooned into just over 56 shares and a value of $3,850 today. That's a market-smashing 1,440% return. And while the current 1.6% dividend yield is small, it is a bit deceiving because I'd be receiving approximately $91 a year in dividends on my original $250 investment. Such a comparison of dividends paid to original investment is not a wise way to value a stock, but it does an excellent job of highlighting the effects of dividend growth over time.

It's also worth noting that Wrigley's stock has been a very steady historical performer -- because the business has been a very steady performer. There have, however, been occasional swoons during which time shares fell by 20% or more. Those short-term blips are the opportunities we need to seize with companies like Wrigley.

Foolish final wordsThe above exercise was fun, easy to understand, and -- at least for me -- enlightening. As my friend became comfortable with such investments, I would strongly urge him to adopt a Motley Fool Income Investor strategy. I think the 3%-plus dividend yield from an Income Investor selection like Diageo(NYSE:DEO) is easy to understand and would boost the overall return on investment.

For now, though, I'll settle for just getting him to start investing for his daughter's future. Whether the money goes toward college or backpacking around Europe, the power of reinvesting dividends over time is something that no one should miss out on.

Want more ideas about putting the power of reinvested dividends to work for you? Test-drive Income Investor for 30 days -- for free. Recommendations from the newsletter have returned an average of 17% since inception, vs. 9% for the S&P 500. Click here to learn more.

NathanParmeleehas no financial interest in any of the companies mentioned. You can view his profilehere. Coca-Cola is a Motley Fool Inside Value recommendation. The Motley Fool has an ironcladdisclosure policy.